Gold was
on a strong uptrend after hitting an 11-month low in July, rising by more than
$120 to a high of $1,808 in mid-August buoyed by the seemingly less hawkish
comments at the July FOMC meeting. However, the prices trended lower
thereafter, after the Fed’s extremely hawkish view on the monetary policy at
the annual Jackson Hole symposium where the Fed chair gave a clear indication that
combating inflation through sharper rate hikes is a top priority for the
central bank. This may involve a weaker economy and job losses, a short-term
pain they are willing to tolerate to fight inflation. This led to a recalibration
of market expectations with gold prices in August closing 3% lower at $1,711. Equity
markets saw a similar reaction with the S&P 500 clocking a three-month high
during mid-August before closing 4% lower. Treasury bonds also sold off with
the benchmark US10-Year yield approaching a two-month high of 3.2%. Yields on
the 10-year Treasury Inflation-Protected Securities moved up sharply in the
month from lows of 0.09 to 0.67, taking a toll on gold.
Given that
a lot of the current inflationary pressures are due to supply-side challenges,
but the Fed is focused on fighting inflation, killing demand seems to be the
way forward signalling significant volatility in financial markets in the
months ahead. Food and fuel supply
disruptions due to the Russia-Ukraine war have been recently exacerbated by
climate shocks around the world. The July inflation print in the US came out to
be 8.5% y/y, which was lower than the consensus expectations and much lower
than the 9.1% registered in June. Although the inflation has moderated a bit, it
is far from the Central bank's inflation target of 2%. Thus, price increases
would continue to dominate headlines for more months to come, keeping the
aggressive tightening window open for the Fed.
Starting
September, the Fed will ramp up the unwinding of its $9 trillion portfolio
by boosting its monthly caps for Treasuries and mortgage-backed securities to
$60 billion and $35 billion, respectively from $30 billion and $17.5 billion
currently. This will further tighten monetary conditions. Also, as per the CME
Fed Watch Tool, markets are pricing in a 74% probability of a 75-basis points
rate hike in the September FOMC meeting, different from the 50 basis points
rate hike bets at the start of the month. The Fed rate is now expected to touch
4% by the end of 2022, a massive 400 basis points increase since the start of
the year.
It’s clear now that
the Fed is prioritizing inflation overgrowth and isn’t risking de-anchoring
inflation expectations. An exceptionally strong jobs market in the US is aiding
the Fed’s hawkish convictions. The number of available positions topped 11.2
million in July indicating two jobs for every unemployed person and the unemployment
rate in August hovering around 3.7%, which is closer to the levels last seen in
February 2020.
Despite
the Fed’s current hawkishness, its conviction to tighten will eventually get
tested when the economic numbers show a meaningful deterioration. As of now, the world’s largest economy is showing subtle signs of slowing with the GDP contracting by 0.6% in the April-June
quarter, after the 1.6% contraction in the first quarter. The S&P Global US
Composite PMI registered 45 in August of 2022, down from 47.7 in July,
indicating a second successive monthly decrease in total business activity.
The spread between US 10-year and 2-year Treasury yields continues to be
negative since July, indicating continued concerns among
investors that the Fed’s aggressive withdrawal of liquidity will push the economy into a recession. With hopes of a Fed
pivot any time soon fading away, there was a flight of money to the US Dollar that
caused the DXY to breach 109 on the upside after touching a one-month low of
104 in August. The strengthening of the dollar led to the rupee depreciating by
0.4% last month. Domestic gold prices outperformed the prices in dollar terms.
Indian gold price closed 1.4% lower compared to dollar prices which closed 2.7%
lower, partly due to the depreciating INR and partly due to the customs duty
tariff increase.
In
contrast, Indian equities performed better than other asset classes with the
Nifty up 3.5% in August. Nifty also performed better compared to the global
ones such as S&P 500 which was down 4% last month. Indian equities are well
placed with strong fundamentals and attractive valuations but are vulnerable to
the Federal Reserve’s policy tightening and a global economic slowdown,
warranting a portfolio allocation to gold. Headwinds like the strengthening US
dollar, rising bond yields and tightening liquidity by central banks will no
doubt put downward pressure on gold, but the precious metal will be supported
by geopolitical tensions, risk aversion and overall commodity inflation,
potentially cushioning portfolios from the equity market volatility. Furthermore,
other regions such as Europe, which are more prone to inflationary shocks, may
warrant the respective Central banks to tighten aggressively creating wide
interest rate differentials with the US and putting downward pressure on the US
dollar. This is likely to support gold prices.
Therefore,
it becomes important to allocate 20% of the portfolio to gold to diversify your
investments, which may help during negative economic and geopolitical
surprises. Moreover, when prices have considerably corrected at these levels,
investors can start accumulating in a staggered manner or systematically with
SIPs. This would ensure a sizeable upside when the gold prices move higher.
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